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How Asia-Pacific regulators approach the ‘E’ of ESG

Understanding a fragmented landscape

Magnus Cattan

Vice President, ICE Fixed Income & Data Services, Asia Pacific

Michelle Wong

Regulatory Research Specialist

The Asia-Pacific’s regulatory landscape has long been fragmented, with jurisdictions having their own timelines and supervisory style. Environmental regulations are no exception.

While all jurisdictions are launching guidelines to help financial institutions manage the risks brought by the transition towards a lower-carbon economy, larger international financial hubs such as Singapore and Hong Kong are already formulating rules and policies to help their economies benefit from the strong interest in ESG. Meanwhile, industrial economies such as China have been setting ambitious carbon reduction goals, rolling out regulations to control pollution and boost green financing.

As such, Environmental regulations in APAC could be broadly classified into three categories based on the primary motive behind the rules:

  • regulations that aim to cut carbon emissions
  • guidelines that help the financial industry manage climate-related risks
  • regulations and policies that help to develop the ESG financial product industry

Cutting carbon emissions

Some governments in APAC have announced their net-zero targets - when the volume of greenhouse gas emissions they add to the atmosphere is no more than the amount taken away - with Hong Kong, Japan and South Korea aiming to achieve carbon neutrality by the year 2050 and China for 2060.

To meet their deadlines, Asian regulators are putting a price tag on excessive carbon emissions and directing funding away from heavy polluters that refuse to make a change.

China, Japan, South Korea and New Zealand have established mandatory carbon markets, which essentially cap the amount of greenhouse gases (GHG) certain firms can emit, and if they wish to emit more than they are permitted, they will have to purchase extra allowances from their counterparts at a market price. The governments will then gradually reduce the cap over time to lower total emissions. Another approach, currently adopted by Singapore, is to tax GHG emissions.

Emission Trading Schemes (ETS) in APAC

ChinaChina National ETS, Regional Pilot ETS
IndonesiaUnder development
JapanCap-and-Trade Program of the Tokyo Metropolitan Government, Saitama Prefecture’s ETS
KoreaKorea Emissions Trading Scheme
New Zealand New Zealand ETS
Philippines Under consideration
TaiwanUnder consideration
ThailandUnder consideration
VietnamUnder development

Besides controlling the volume of pollutants going into the atmosphere, directing the flow of money away from high GHG emitters lacking a concreate sustainability plan is another way to indirectly curb emissions. More banks are expected to help their clients with unsatisfactory ESG performance to adopt more sustainable business practices, and in some cases, stop doing businesses with certain clients.

For example, the Monetary Authority of Singapore (MAS)’s series of Guidelines on Environmental Risk Management expect banks to conduct enhanced due diligence on customers with higher environmental risks. When necessary, banks may consider working with them to establish carbon emission reduction targets and incentivize them to achieve their targets by offering a lower cost of borrowing. If the customer refuses to manage its risk adequately, the banks can consider raising loan pricing to reflect the cost of the additional risk, applying limits on the loan exposure, or even exiting the customer relationship.

Similar guidance is found in the Australia Prudential Regulation Authority (APRA)’s draft prudential practice guide on Climate Change Financial Risks.

Meanwhile, China’s central bank is taking a slightly different approach by conducting quarterly evaluations of banks’ performance in green finance businesses since early this year. Banks will be scrutinized based on criteria such as their total value of green finance businesses against total assets and against other banks, as well as the annual growth and risks of their green businesses.

APAC Bank Sustainability Regulations

Australia APRA Draft Prudential Practice Guide on Climate Change Financial Risks
ChinaPBOC Notice on Green Finance Evaluation Plan for Banking Financial Institutions
Hong Kong HKMA Draft SPM Module GS-1 on “Climate Risk Management”
Malaysia Under development
PhilippinesBSP Circular No. 1085 Sustainable Finance Framework, BSP Circular No. 1128 Environmental and Social Risk Management Framework
SingaporeMAS Guidelines on Environmental Risk Management for Banks

Managing Climate-Related Risks

As governments around the world seek to reduce carbon emissions, the unprecedented scale of the energy transition could pose several risks to the financial industry.

As a report by the Financial Stability Board has pointed out, transition risks arise when a policy change raises the costs of carbon emission and ramps up production costs of some businesses, thinning their profits and driving down their share prices. As a result, the value of assets held by banks and asset managers may depreciate while banks may find it harder to recover debts from stressed businesses.

Besides transition risk, physical risk is another major category under the climate-related risk umbrella. Physical risk such as natural disasters could destroy housing and decrease the value of mortgage collateral, reducing borrowers’ creditworthiness and impairing the solvency of banks. As banks lessen their support to the real economy, stagnant economic growth could in turn amplify losses borne by financial institutions. As governments spend large amounts on post-disaster reconstruction, sovereign default risk could rise and be transferred to bond holders across borders.

In response, regulators across APAC have been rolling out requirements for banks to manage climate-related risks and conduct scenario analysis. Singapore has finalized their rules while Hong Kong and Australia are in the consultation stage. Malaysia is expected to launch its reference guides in Q4 of 2022 while China is exploring a framework.

Under the Hong Kong Monetary Authority (HKMA)’s drafted guidelines on climate risk management issued in July, banks are required to assess how climate-related risks affect the traditional risk types, including credit risk, market risk, liquidity risk, operation and legal risk, as well as strategic risk.

At a portfolio level, the HKMA’s guidelines indicated that banks can identify risky asset portfolios by looking at the client’s physical locations and energy usage to assess how vulnerable they are to climate change. At a counterparty level, banks can analyze their counterparty’s financial position, transition strategy and exposure to stranded assets.

The purpose of scenario analysis is for banks to assess the vulnerability of their financial positions to climate change in terms of its profitability, liquidity, and capital adequacy.

As there are still many uncertainties around how the transition will unfold, banks are expected to consider multiple scenarios, including an orderly and a disorderly pathway to a lower-carbon economy.

For each of the scenarios, banks can adjust their assumptions on different factors such as a rise in sea level and carbon prices to manifest physical and transition risks when simulating different scenarios. Banks can then assess how these factors could impact their revenue, costs, asset values and borrowers’ repayment ability, and then apply them to major risk categories and the aggregate impact on their financial position.

Besides requiring banks to do their own scenario analysis at an entity-level, regulators in Australia, Hong Kong, Japan, New Zealand, Singapore and South Korea are set to run climate stress tests at a jurisdiction-level to test the resilience of the banking sector as a whole.

For the buy side, incorporation of environmental risks into research and portfolio construction is required for asset managers in Singapore under the MAS’ Guidelines on Environmental Risk Management and for fund managers in Hong Kong under the SFC’s Revised Fund Manager Code of Conduct. Scenario analysis is expected from asset managers in Singapore, where environmental risk is assessed to be material, and from larger fund managers in Hong Kong if it is assessed to be useful.

However, to carry out the above risk management measures, the availability of data is key. Under HKMA’s drafted regulations, banks should build capabilities to address any information and data gaps, such as by obtaining from clients or data providers.

Regulations Applying to Asset/Fund Managers in APAC

Australia APRA Prudential Practice Guide on Investment Governance (SPG 530), APRA Draft Prudential Practice Guide on Climate Change Financial Risks (apply to registrable superannuation entity licensee)
Hong Kong SFC Fund Manager Code of Conduct, SFC Circular to management companies of SFC-authorized unit trusts and mutual funds - ESG funds
IndiaSEBI Consultation Paper on Introducing Disclosure Norms for ESG Mutual Fund Schemes
JapanJapan’s Stewardship Code
SingaporeMAS Guidelines on Environmental Risk Management for Asset Managers
TaiwanFSC Principles for Disclosure Supervision and Monitoring of ESG-Related Themed Securities Investment Trust Funds

To increase the accessibility of such data, disclosures of ESG information are increasingly required from corporates, ideally in a specific format so that data are comparable across firms. Requirements are moving from a comply-or-explain approach towards a mandatory nature, as well as expanding in scope from covering listed companies to including other sectors.

Hong Kong has enhanced its comply-or-explain ESG reporting requirements for listed companies by incorporating certain important elements of the Taskforce on Climate-related Financial Disclosures (TCFD) Recommendations last year, and is now making progress towards mandating similar requirements across relevant sectors by 2025. Singapore, which initially required comply-or-explain sustainability disclosures from listed companies, is now expecting financial institutions to disclose by mid-2022 and proposing to mandate more sectors of listed issuers to report in alignment with the TCFD recommendations by 2025. Japan is seeking to require TCFD-style sustainability disclosures from larger listed companies in 2022 and from all companies that submit annual securities report after fiscal 2023. New Zealand is on track to mandate TCFD-style disclosures from most listed issuers and financial institutions from 2024 at the earliest.

Some authorities are also stepping in to help fill the data gaps needed for assessing physical risks of their localities. For example, Australia’s APRA has been looking for entities to provide physical climate risk modelling capabilities, while Malaysia’s committee on Bridging Data Gaps will create a catalogue of climate data to support scenario analysis and other purposes.

Promoting the growth of ESG financial product markets

Apart from risks, a surge of attention to sustainability brings plenty of opportunities. The volume of money flowing into ESG financial products has grown significantly in recent years.

To ensure a sustainable and healthy ESG market, regulators are starting to put rules around what can be called a green financial product to prevent greenwashing from impairing investors’ confidence in the market.

To achieve this, having a taxonomy is one approach many regulators have utilized to create a common language on the definition of green activities.

China, for example, has a Catalogue of Green Bond Endorsed Projects, which essentially gives a list of eligible industries and projects for which green bond issuers can raise fund.

In April 2020, Malaysia’s central bank also launched a Climate Change and Principle-based Taxonomy which took a rather different approach from China’s prescriptive catalogue. The taxonomy sets out five guiding principles and classifies economic activities into three broad categories, namely climate supporting, transitioning, and watchlist. Economic activities fall into different buckets based on with which of the five principles they are in line. The regulator believes this approach could avoid disruptive exclusions and dislocation which could lead to a disorderly transition.

Meanwhile, Singapore has a more granular approach in its taxonomy proposed in January, seeking to classify sectors using international classification codes and categorize activities into buckets based on quantitative thresholds.

Similarly, Thailand and Indonesia are seeking to develop their own taxonomies, while a regional taxonomy has been developed by the Association of Southeast Asian Nations (ASEAN).

Taxonomies in APAC

ASEANASEAN Taxonomy for Sustainable Finance
BangladeshGreen Products Eligible for Financing by Banks and Financial Institutions
ChinaGreen Bond Endorsed Projects Catalogue, Common Ground Taxonomy – Climate Change Mitigation (China & EU)
Malaysia BNM Climate Change and Principle-based Taxonomy, SC Sustainable and Responsible Investment Taxonomy (Planning)
MongoliaMongolian Green Taxonomy
PhilippinesUnder development
SingaporeGFIT Proposed Taxonomy
VietnamSBV Green Project Catalogue

Apart from reaching a consensus on what is considered green, some regulators go further to make sure that ESG fund providers are attaining the green objectives that they claim to be achieving.

Hong Kong SFC has recently enhanced the disclosure requirements for ESG funds to require periodic assessment and reporting to explain how the fund has attained its ESG focus. Taiwan followed suit to enhance its disclosure requirement for ESG-themed funds a month later, while India recently launched a consultation on introducing disclosure requirements for ESG mutual funds. Singapore and Japan have hinted at similar plans.

In addition to maintaining the quality of the expanding ESG markets, some governments are launching policies and initiatives to raise their competitiveness in the region. For economies that rely on the financial industry, the rise of the ESG markets presents valuable opportunities in creating new jobs, attracting foreign investment and promoting economic growth.

Singapore for example, has dedicated resources to setting up research and training centers to promote innovation and worked with private sectors and international bodies to anchor global voluntary carbon market activities. The MAS also set up a US$2 billion green investments program to place funds with selected asset managers who are committed to drive regional green efforts.

Hong Kong is stepping up green finance policies by setting up working groups to bolster cross-sector efforts in capacity building, thought leadership and policy development. It also actively explores opportunities in mandatory and voluntary carbon markets in China and overseas while launching grant schemes for eligible green or sustainable bond issuers and loan borrowers.

The leadership of the two Asian financial centers is further evidenced by the Bank for International Settlements (BIS)’ decision to set up their Innovation Hubs in Singapore and Hong Kong.

APAC could be perceived as lagging the EU with ESG regulations, yet many regulators have been carefully analyzing the pros and cons of global policies before adapting them to their domestic markets. And while fragmentation may create operational complexity, the variety of supervisory styles allows regulators to test different approaches and learn from each other’s successes and failures.